- Cost of Sales/Goods Sold/Services
- Gross Profit
- Selling, General and Administrative Expenses
- Depreciation and Amortization
- Operating Profit
- Other Non-Operating Income and Expenses
- Interest Income / Expense
- Income Before Taxes
- Income Taxes
- Net Income
- Important Characteristics of Items in the Income Statement
- Want to test your understanding?
An income statement is a report that shows how much revenue a company has earned in a given period of time (e.g., 3 months, 6 months, or a year). The Income Statement is also referred to The Consolidated Statement of Earnings, The Profit and Loss (P&L) Statement, Statement of Revenues and Expenses.
The income statement shows the costs and expenses associated with generating that revenue. The literal “bottom line of the statement usually shows the net income or losses of the business. From this, you can see how much the company earned or lost during the period in question.
The income statement answers the question, “How well is the company’s business performing?” Or more simply put, “Is it making money?” A company must be able to bring in more money than it spends, or it won’t stay in business long. Companies with low expenses relative to revenues – and therefore high profits relative to revenues – are particularly attractive for investment because a greater portion of every dollar the company takes in directly benefits you, the shareholder.
To understand how the income statement is structured, think of it like a staircase. You start at the top with the total amount of revenue generated during the accounting period. Then you go down one step at a time. At each step, you subtract certain costs or other operating expenses associated with earning the revenue. At the bottom of the staircase, after subtracting all expenses, you learn how much the company earned or lost during the accounting period. This is often referred to as the “bottom line.” Below is an example of the income statement for the Coca-Cola Company 2021.
The revenue section is usually the simplest part of the income statement. Often there is only one figure that represents all the money a company has taken in by supplying products/services in a given period, although large companies sometimes break down revenue in ways that provide more information (e.g., segregated by geographic location or business segment). Revenues are also commonly known as sales. Because banks and some other financial institutions make their money from interest – i.e., they do not really “sell” anything – their income statements look different.
Revenue is recognized in the income statement when the product has been delivered or the service has been rendered and the seller is reasonably certain that the product will not be returned. Refunds and returned goods are not considered in revenue. Both the risk and the rewards of ownership must be transferred from the buyer to the seller for the transaction to be considered complete.
Keep in mind that not all income is revenue as a company may have other income streams, which are not related to its main operations, such as:
- Interest income earned from investments (recorded as non-operating income on the income statement)
- Income received from a legal settlement (if material, identified as a separate line item on the income statement below revenue) or netted against operating expenses
Cost of Sales/Goods Sold/Services
Cost of sales/goods sold/services represents all expenses incurred directly in producing the goods or services sold by a company. They represent the “per unit” cost of selling products/services. Example of costs for physical products:
- Cost of raw materials
- Cost of components
- Goods bought for resale
- Direct labour costs of production
- Shipping and delivery costs
- Any other costs directly associated with the generation of revenue
Some companies may include depreciation of fixed assets where the fixed assets are to produce the goods or services sold by the companies.
Lots of these costs are not going to be immediately recognized. For example, “Goods bought for resale” are only recognized when revenue from their sale is recognized.
Below are examples of expenses that, once sold, would be classified as cost of goods sold:
|Inventory||The cost of furniture that Homeritz sold|
|Direct labor||The cost of regular working hours, as well as the overtime hours worked in H&M outlets|
|Factory overhead (indirect costs)||Equipment maintenance costs in Top Glove and Petronas Chemical factories|
|Shipping & delivery costs||Cheniere Energy to distribute Liquefied natural gas (LNG)|
|Cost of materials and traffic expenses||The cost of merchandises and commissions in Digi and Vodafone outlets|
Spectrum licence fees, network costs, Internet traffic costs to serve Digi and Vodafone mobile users.
|Service and delivery costs||Energy cost, transmission cost, distribution cost incurred when Tenaga and Duke Energy provide electricity|
Gross profit is a company’s total revenue (equivalent to total sales) minus the cost of goods sold. Higher gross profit is always better.
[Gross Profit]=[Revenue]-[Cost of Sales]
Selling, General and Administrative Expenses
Selling, general, and administrative expenses (also known as “SG&A”) consist of several types of costs. Selling expenses are those expenses incurred in attempting to generate sales for the company. General and administrative expenses, on the other hand, include most of the overhead costs of running a company’s business. Generally, companies do not report the costs in detail. Examples of SG&A:
|Selling Expenses||General and Administrative Expenses|
|Costs for marketing personnel||Administrative employee compensation and benefit costs|
|Transport costs||IT infrastructure and communication costs|
|Consumer advertising programs||Office rent and supplies|
|Internal sales forces||Professional services|
|Brokerage costs||Other general corporate expenses|
Depreciation and Amortization
When a company purchases an asset that it intends to use over a period of time, such as a piece of factory equipment or a building, the entire cost of the asset isn’t immediately recognised in the income statement. Instead, the company expenses the asset gradually over the estimated useful life of the asset. This expense represents the normal wear and tear of the building or facility over time and is referred to as depreciation expense. Depreciation reduces the asset indirectly through an accumulated depreciation account. These items are non-cash expenses related to the allocation over time of capital acquisitions that last more than 1 year.
Below shows an example of depreciation of an asset.
Beginning of year
|x||Depreciation Rate||=||Annual Depreciation Expense|
Amortization is like depreciation, except that amortization refers to intangible assets, or assets that do not physically exist, such as a brand name. Amortization directly reduces the asset on the balance sheet. Goodwill cannot be amortized, even if it is a kind of intangible assets.
Depreciation and amortization are income tax deduction but does not affect cash flows from operating activities. Therefore, both expenses appear in the income statement, even though they are non-cash expenses.
Often, depreciation and amortization are already included in the other expenses mentioned above, so you may not see them listed separately on the income statement. However, the amounts for depreciation and amortization are shown (sometimes combined) in the cash flow statement.
Operating profit is the profit earned from the normal core business of a company. Operating profit measures the profit (or loss) that a company can earn from its main operations.
[“Operating Profit”]=[“Gross Profit”]-[“Total Operating Expenses”]
Other Non-Operating Income and Expenses
Everything in this section impacts a company’s taxes and represents something in the current period, but these items are not part of the company’s core business of selling products/services. Some of these items – Gains and Losses, Write-Downs, and Impairments – are non-cash, which means they reduce a company’s taxes but don’t result in a cash payment. Example of items:
- Gains/losses from investments
- Gains/losses from property or asset sales
- Gains/losses from currency exchange
- Dividend income
- Insurance claim
- Restructuring charges
- Government grant
Although “Share of Profit of Joint Ventures and Associates”, “Interest Income” and “Interest Expense” are part of other non-operating expenses, they are reported in separate lines.
Interest Income / Expense
Interest income is the money companies make from keeping their cash in interest-bearing savings accounts, money market funds, and the like. On the other hand, interest expense is the amount of money companies pay in interest on borrowed money. In some income statements, interest income and interest expense are reported separately. In some income statements, the two figures are combined. Interest income and expense are then added to or subtracted from operating profits to arrive at income before taxes.
Income Before Taxes
Income before tax is a profitability measure that looks at a company’s profits before paying corporate income tax. This measure deducts all expenses from revenue including interest expenses and operating expenses, but does not take into account the payment of taxes.
[“Income Before Taxes”]=[“Operating Income”]+[“Other Income / Expense”]+[“Share of Profits”]
The tax is imposed on net taxable income. Bear in mind, tax expense doesn’t equal the actual cash taxes paid!
This topic can get esoteric. Generally speaking, because of the ability of companies to defer certain taxes, the tax expense companies recognize on their income statement does not equal that actual cash taxes they have to pay for the same period.
Net income is what is left for a company after all expenses have been accounted for. It is sometimes referred to as a company’s “bottom line”. It tells you how much the company made or lost during the accounting period. Did the company make a profit or lose money?
Important Characteristics of Items in the Income Statement
To appear on the Income Statement, each item must meet the following criteria:
- It must correspond to only the period shown on the Income Statement – If a company paid for an asset that will last for 20 years, the initial money spent would not appear on a 1-year Income Statement. Monthly rent would appear.
- It must affect the company’s taxes – For example, interest paid on debt is tax-deductible, so it appears on the Income Statement. But repaying debt principal is not tax-deductible, so it does not appear on the Income Statement. Items like following are tax-deductible too.
- Do not need to be related to a company’s operational activities – Gains/Losses and impairment charges appear, but they are not related to selling products to customers.
- Do not need to be cash expenses or cash revenue – Depreciation and Amortization are both non-cash expenses.
The following items will never appear on the Income Statement because they have no tax effect and do not correspond to the period reported on the Income Statement.
- Purchases of investments
- Purchases of property, plant and equipment
- Payments of debt
- Issuances / Purchase of stock
Want to test your understanding?
Take 10 minutes to construct an income statement based on a given scenario.